The politics of economics

In the wake of a few significant elections in the American states of New York, New Jersey and Virginia, a lot of pundits are putting their spin on what these elections mean for Barack Obama and his political agenda. On the whole, I find most of the conclusions partisan leaps of faith.

So, I wanted to take this issue on and outline my thoughts on American politics and the feedback loop with the economy. I will then try to take on what the election last November and just this past week meanregarding Obama’s political agenda and the missteps I believe he made early in his tenure as President.

Confabulation and the human need to explain

First, let me start off with a basic concept of behavioral psychology: confabulation. Back in April, I quoted from an article in New Scientist about how people will develop false narratives to explain away decisions already made. This is called confabulation. The article says:

As anyone who has ever been in a verbal disagreement can attest, people tend to give elaborate justifications for their decisions, which we have every reason to believe are nothing more than rationalisations after the event. To prove such people wrong, though, or even provide enough evidence to change their mind, is an entirely different matter: who are you to say what my reasons are?

But with choice blindness we drive a large wedge between intentions and actions in the mind. As our participants give us verbal explanations about choices they never made, we can show them beyond doubt – and prove it – that what they say cannot be true. So our experiments offer a unique window into confabulation (the story-telling we do to justify things after the fact) that is otherwise very difficult to come by. We can compare everyday explanations with those under lab conditions, looking for such things as the amount of detail in descriptions, how coherent the narrative is, the emotional tone, or even the timing or flow of the speech. Then we can create a theoretical framework to analyse any kind of exchange.

What experimenters here have shown is that there is a real human need to explain. Things happen for a reason, don’t they? Why did the stock market rally? Why did Harry do that? Why didn’t we do something to stop this? Why did I vote for that guy back then, when I now don’t like him as much?

To the degree there is an explanation void, it will be filled. The question is: filled with what?

Confirmation bias and the psychology of politics

In politics, how the void gets filled has much to do with philosophical/political predisposition and one’s world view.

Drew Westen, a professor of psychology at Emory University, published an interesting book a few years back called “The Political Brain.” Recently, Westen has had some important things to say about the psychology of the health care debate (see Washington Post article here). But, in the book, the most memorable political psychological experiment Westen described is very much related to confabulation. I quoted from Wikipedia’s synopsis of this experiment to explain confirmation bias in the econoblogosphere back in May:

In January 2006 a group of scientists led by Westen announced at the annual Society for Personality and Social Psychology conference in Palm Springs, California the results of a study in which functional magnetic resonance imaging (fMRI) showed that self-described Democrats and Republicans responded to negative remarks about their political candidate of choice in systematically biased ways.

Specifically, when Republican test subjects were shown self-contradictory quotes by George W. Bush and when Democratic test subjects were shown self-contradictory quotes by John Kerry, both groups tended to explain away the apparent contradictions in a manner biased to favor their candidate of choice. Similarly, areas of the brain responsible for reasoning(presumably the prefrontal cortex) did not respond during these conclusions while areas of the brain controlling emotions (presumably the amygdala and/or cingulate gyrus) showed increased activity as compared to the subject’s responses to politically neutral statements associated with politically neutral people (such as Tom Hanks).[2]

Subjects were then presented with information that exonerated their candidate of choice. When this occurred, areas of the brain involved in reward processing (presumably theorbitofrontal cortex and/or striatum / nucleus accumbens) showed increased activity.

Dr. Westen said,

None of the circuits involved in conscious reasoning were particularly engaged… Essentially, it appears as if partisans twirl the cognitive kaleidoscope until they get the conclusions they want… Everyone… may reason to emotionally biased judgments when they have a vested interest in how to interpret ‘the facts.’[3]

In essence, political partisans with a well-developed political world view were confronted with data that did not fit their particular view. This created cognitive dissonance and mental stress (remember, the brain areas for reason were not activated here, emotions were at play). Their brains, rather than trying to resolve the conflict objectively, looked for ways to incorporate the new information into the previous pre-conceived view. When the subjects successfully accomplished this back flip, they were massively rewarded by the areas of the brain for pleasure.

In sum, our brains are NOT hard-wired for non-confirmatory evidence. We are not rewarded for seeking non-confirming data. Therefore, we generally seek confirmatory evidence after we have made any decision.

When you read the narratives of the recent election results, you should realize that confirmation bias is very much at play in tweaking the conclusion to fit a preconceived world view. A perfect example is a recent piece by Charles Krauthamer in the Washington Post.

Speaking of a huge Democratic loss in Virginia, Krauthamer says:

In the aftermath of last year’s Obama sweep, we heard endlessly about its fundamental, revolutionary, transformational nature. How it was ushering in an FDR-like realignment for the 21st century in which new demographics — most prominently, rising minorities and the young — would bury the GOP far into the future. One book proclaimed "The Death of Conservatism," while the more modest merely predicted the terminal decline of the Republican Party into a regional party of the Deep South or a rump party of marginalized angry white men.

This was all ridiculous from the beginning. The ’08 election was a historical anomaly. A uniquely charismatic candidate was running at a time of deep war weariness, with an intensely unpopular Republican president, against a politically incompetent opponent, amid the greatest financial collapse since the Great Depression. And still he won by only seven points.

Exactly a year later comes the empirical validation of that skepticism. Virginia — presumed harbinger of the new realignment, having gone Democratic in ’08 for the first time in 44 years — went red again. With a vengeance. Barack Obama had carried it by six points. The Republican gubernatorial candidate won by 17 — a 23-point swing. New Jersey went from plus-15 Democratic in 2008 to minus-four in 2009. A 19-point swing.

Obama also benefitted in 2008 from unique circumstances with the recession and economic crisis favoring a change candidate. That uniqueness can be seen in the huge drop in young and black voters last week as well as the switch in independent voter allegiance from Democrat to Republican. I guarantee you we would have seen similar results in favor of George W. Bush had the recession of 2001 and 9/11 occurred one year earlier. None of these factors favored Democrats in 2009.

Krauthamer goes on to make some partisan claims about left-leaning agendas, hubris and taxation that I found unconvincing (Clive Cook also does this). I wished he had stopped here because he makes a valid point: the 2008 election was not some magical moment in American history in which we saw a sea change in political alignment at one moment in time. That’s confabulation, pure and simple.

What happened is Americans voted for those people who they felt would change course because they felt the country was headed in the wrong direction. That’s certainly what exit polling told us in November 2008. Making up some other explanation is not necessary.

I know change when I see it and this is not it

So, what Charles Krauthamer and Clive Cook are doing along with Frank Rich and Paul Krugman is filling the explanation void. I agree with the analysis, but some of the conclusions are more dubious. I have done my share of filling that void (I see Frank Rich’s narrative as the one closest to mine).

But, for a moment, let’s leave the explanations aside. The great thing is humans are capable of complex decision-making and thought without having to explain those decisions. We know how to distinguish a frog from a prince and a pig from a princess – no explanation required.

And so it is here again. If you asked 1000 people in those exit polls from November 2008 – or even last week, “what would make you know America was headed in the right direction,” you probably would have gotten 700 different answers.

But, one thing is clear: Since January 20th, a lot of people are saying to themselves, “I know change when I see it and this is not it.” That’s what all polls are saying. So, whatever Obama and the Democratically-controlled Congress are doing, it’s not working.

Enter the Demagogue

That’s where demagoguery comes into play. Demagogues love an explanation vacuum. Since time immemorial, where there has been public disenchantment with the status quo, there has always been some demagogue waiting in the wings with a ready-set explanation of what’s wrong and how they were going to fix it. These are people who are considered fringe elements in good times, but when economic hardship comes their ready-made explanations and confabulation become a toxic mix which propels them to prominence. (For the record, I am not connecting the gentlemen mentioned above with demagoguery. I am making a separate point here).

I would argue, that’s where we are right now. The global economy has just experienced an incredible shock. In the United States, more than one in six is unemployed or underemployed. Personal bankruptcies and foreclosures are still happening in record numbers. The economic situation is, in a word, grim.

Therefore, people are going to more open to a wider range of ideas and this is a prime opportunity for demagogues to advantage themselves and their allies. It also should make any incumbent politician very afraid of losing their job.

With this in mind, I look back to the early days of Barack Obama’s tenure and I can’t help but conclude that his economic strategy was too timid, too much aligned with the status quo. It’s not as if this should be a shocker; I pointed this out in January and again in February. His economic team erred in believing, as the Bush Administration had done, that the economic and financial situation was better than it was. Remember, Obama’s stimulus plan was based on a forecast of 8.0% unemployment.

Future policy decisions

But that ship has sailed and here we are a year after Obama’s election in a technical but unsatisfactory statistical recovery. What should Obama do going forward?

Well, first of all, what he needs to do is give voters a sense that the recovery is for real. And that means unemployment, foreclosures, and stagnant personal income must be attacked. On some level, the health care debate is a net negative in that it consumes a lot of political capital without any obvious and immediate economic benefit. The bailouts and financial reform agenda also have been net negatives as well for similar reasons but also because they have not been seen as fundamental change and they further disenchantment.

Moreover, we know that the explanation vacuum is being filled by voices decrying big government and socialism. If you listen to people like Charles Krauthamer, you are likely to see Obama as a dangerous shift in America to the left. He makes a compelling argument which will sway those who are constitutionally predisposed to hating big government or deficit spending. So this means Obama is now constrained. In my view, fiscal stimulus is a political non-starter.

So, I see jobs as the first area for Obama to attack. The question is whether he does this directly via some modified private-sector controlled W.P.A.-type program or indirectly via something like a payroll tax cut. After jobs comes foreclosure. Personal income and taxes are the least important area going forward (especially as any tax cuts will either increase deficit spending or have to be made up by tax increases elsewhere).

If the economy turns up vigorously and permanently, we can put some of these thoughts to rest. You have to believe many fewer people would be yelling socialism or corporate communism if we were in a robust upturn. However, I don’t think that is a likely economic scenario. Even so, the unique circumstances of 2008 are unlikely to be repeated. That spells trouble for the Democrats in 2010 and 2012 unless they start doing something dramatically different.

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty five years of business experience. He has also been a regular economic and financial commentator in print and on television for the past decade. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College.

“Therefore, people are going to more open to a wider range of ideas and this is a prime opportunity for demagogues to advantage themselves and their allies. It also should make any incumbent politician very afraid of losing their job.”

We’re not in the hands of demogogues now? These are stable, well intentioned folks that lead us?

I say bring on as many fresh “demogogues” as you can, anything, if it will just bring an end to the cesspool that is our public life.

Element says 9 years ago

People should factor in the fairly high probability that US leaders are more likely to get the timing and proportions of stimulus removal more-or less ‘wrong’, rather than almost ‘right’. And keep in mind that many countries face the exact same problem, so the chances are high that more than 50% of these will get it more-or-less ‘wrong’, and fail to sustainably recover on the first attempt.

That could be a significantly under-estimated problem–politically.

But there’s a more worrying and immediate problem–not enough state tax revenue is being collected. This is going to force US states to raise taxes quite soon, regardless of the politics or questionable economics of doing this in a ‘weak-recovery’ — recession by any other name.

Like it or not, structural budget shortfalls must be and will be met, with higher surcharges, until that also proves inadequate. This will happen before Federal stimulus is withdrawn, so will tend to cancel-out each other.

The alternative is Obama uses public money (even sooner) to bailout any defaulting US states (probably several ‘big-economy’ states—it will be very expensive). Obama is compelled to use public money in the event of any actual state default. Now imagine living in a state that didn’t default but now have to pay an extra Federal tax burden, plus have a slower growth-rate ‘recovery’ because your neighbour state defaulted.

National Federalism has a sting in the tail.

As with the stimulus withdrawal dilemma, this tax problem isn’t US specific. Tax revenues are cliff-diving–globally.

In a “new normal” there’s a smaller global tax-take. The visible effects are still barely noticeable (in most countries) but in two years the effects will show up. Potholes that don’t get fixed after it rains, sewers that don’t get repaired for months, and only after pressure is applied, etc. It’s not here yet, but will come.

If the globe gets another leg-down, or the sawtooth ‘recovery’ (Edward expects), the taxation shortfall gets worse each cycle as unemployment rises. Plus withdrawal of the stimulus becomes more economically unthinkable so is delayed each time, thus deficits and debt keep growing (as per Japan).

It’s a ‘d’epression — ‘phoney-war’ phase.

On Thurs Nov 5th 2009 an excellent new Australian series, made for global TV distribution, called “Addicted to Money” was first aired on ABC TV. The host, David McWilliams, finalised the first installment of the series with an absolutely blistering summary of recent events, ending with; “…Make no mistake about it, this was the biggest scam in financial history. Tens of millions of jobs have been lost, livelihoods wiped out, and the prospects of a generation, a young generation, have been mortgaged. And the culprits, the bankers, who paid themselves enormously, the regulators who turned a blind eye, and even the governments who cheer-led–they are not going to end up in a place like this [recorded in a high-security prison]. They’re never going to be bought to Justice. And just to make matters worse, as we speak, your money is being used to bail these guys out. Now, how does that make you feel?” [walks off cam as credits roll]

Your points about states raising taxes is on the money. This downturn is all about a raising disposable income in order to maintain some semblance of aggregate demand while the private sector deleverages. It is a tricky operation that will be years in the doing. Raising taxes and/or cutting spending decreases income and demand and creates a deflationary bias. he federal government is the only actor in the short-term that can prevent that deflationary bias from become a spiral and liquidity trap.

Element says 9 years ago

Oops! Forgot the quote;

It highlights the issues of judging the timing of when to remove depressionary stimulus and the distortions to decision-making that will inevitably occur, culminating in withdrawal that’s too early to sustain a recovery ‘escape-velocity’.

—

“…In dealing with the continued weak economy, our leaders are so determined not to repeat the perceived mistakes of the 1930s that they are risking policies with possibly far worse consequences designed by the same people at the Fed who ran policy with the short-term view that asset bubbles don’t matter because the fallout can be managed after they pop. That view created a disaster that required unprecedented intervention for which our leaders congratulated themselves for doing whatever it took to solve. With a sense of mission accomplished, the G-20 proclaimed “it worked.” We are now being told that the most important thing is to not remove the fiscal and monetary support too soon. Christine Romer, a top advisor to the President, argues that we made a great mistake by withdrawing stimulus in 1937. Just to review, in 1934 GDP grew 17.0%, in 1935 it grew another 11.1%, and in 1936 it grew another 14.3%. Over the period unemployment fell by 30%. That is three years of progress. Apparently, even this wuld not have been enough to achieve what Larry Summers has called “exit velocity.” Imagine, in our modern market, where we now get economic data on practically a daily basis, living through three years of favorable economic reports and deciding that it would be “premature” to withdraw the stimulus. An alternative lesson from the double dip the economy took in 1938 is that the GDP created by massive fiscal stimulus is artificial. So whenever it is eventually removed, there will be significant economic fall out. Our choice may be either to maintain large annual deficits until our creditors refuse to finance them or tolerate another leg down in our economy by accepting some measure of fiscal discipline.” …” – Liquor before Beer – David Einhorn, Greenlight Capital, Oct 2009.